Taxation of DamagesEnd the inequity

Special to The National Law Journal
September 17, 2007

ouse and Senate committees are considering the Civil Rights Tax
Relief Act of 2007. The CRTRA would remedy anomalies in the treatment
of damages obtained by employment discrimination victims and other
civil rights plaintiffs, which disadvantage them by comparison
with victims of physically injurious torts. A section of an earlier
version, enacted in 2004, went part way toward rejecting this harsh
approach by ending taxation of attorney fees to both the lawyer
and the client. Congress should finish the job this session. Passage
of the two remaining provisions — one dealing with noneconomic,
the other with economic harm — would aid both workers and
defendant companies while striking a blow for tax equity.

The following analysis illustrates the problem. Suppose, first,
that you have been hurt in a car accident caused by another driver's
negligence. After suing him, by verdict or settlement you recover
damages for the earnings you lost when out of work, for pain and
suffering — including your mental and emotional anguish — and
for any medical expenses you had to pay. On April 15, will Uncle
Sam take a slice of this loaf? The answer is no, because Internal
Revenue Code § 104(a)(2) does not include in gross income "damages
(other than punitive damages) received . . . on account of personal
physical injuries or physical sickness."

Next, suppose that your former boss sexually harassed you — to
the extent that you incurred a nervous breakdown, necessitating
psychotherapy — then dismissed you, after you filed charges
against him. Ultimately, you obtain an award representing the following
items: back pay for the time you spent regaining your health and
securing a new job; "front pay," to cover a reduction
in your future earnings and a forfeited pension; and compensation
for emotional pain and unreimbursed costs of treatment. You also
get your attorney fees, as provided by statute in civil rights
cases. Will you owe tax on any of these items?

The answer is yes: on all but the legal and medical expenses.
Section 104(a)(2) states: "[E]motional distress shall not
be treated as a physical injury or physical sickness." This
holds true even when mental anguish generates bodily symptoms,
as typically occurs, except that this proviso does not apply to "amount[s]
paid for medical care . . . attributable to emotional distress." Moreover,
if the award preceded Oct. 22, 2004, you would be taxed on the
fee portion despite the fact that you never saw one cent of it!
C.I.R. v. Banks, 543 U.S. 426 (2005). (Under the double-taxation
regime, the interaction of the rules on miscellaneous itemized
deductions and the alternative minimum tax has sometimes caused
the "victorious" employee to pay more to the Internal
Revenue Service than she realized from her case!)

One might wonder why mental suffering stemming from whiplash should
be recompensed tax-free, while reparations for misery arising from
months or years of job discrimination — which can produce
medical problems as grave as stroke or heart attack — must
be shared with Uncle Sam. The difference may reflect worry that
wily plaintiffs will "con" juries into bestowing unwarranted
sums for dubious harms. But that could be alleviated by less blunt
instruments than the Tax Code: e.g., remittitur. The variance might
also be due to devaluation of "mere" emotional disturbance,
not grounded in tangible trauma, or to concerns specific to employment
(or civil rights) actions. The latter explanation draws support
from the fact that until 1996, Section 104(a)(2) excluded from
income all "damages on account of personal injury." Significantly,
only after the Civil Rights Act of 1991 did plaintiffs suing under
Title VII of the Civil Rights Act of 1964 and the Americans with
Disabilities Act secure the right to noneconomic compensatory damages.

Unfair disparities

This development cannot, however, account for the second major
difference in the treatment of discrimination damages. As a result
of U.S. Supreme Court decisions in the 1990s, followed by the 1996
Code revision, back and front pay in addition to emotional distress
sums are taxable. While construing "income" to cover
wages has much greater justification than extending the label to
pain and suffering, the contrast with the handling of economic
damages in physical torts still violates notions of fairness.

The CRTRA would wholly overturn the status quo respecting mental
anguish damages by making these nontaxable again. As to recoveries
for lost pay, it would grant a partial remedy: permitting awards
to be averaged over the years the money would have been earned,
thus lowering marginal rates. This more than "half loaf" solution
goes far to correct the current injustice toward victims of discrimination.
Further, by encouraging lower (because less taxable) settlements,
it would benefit business as well. The CRTRA — a win-win — deserves
passage.